Cholamandalam Investment and Finance Company Limited (NSEI:CHOLAFIN) is currently trading at a trailing P/E of 25.1x, which is lower than the industry average of 27.4x. While CHOLAFIN might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for Cholamandalam Investment and Finance
What you need to know about the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for CHOLAFIN
Price per share = ₹1454.2
Earnings per share = ₹58.029
∴ Price-Earnings Ratio = ₹1454.2 ÷ ₹58.029 = 25.1x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CHOLAFIN, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
At 25.1x, CHOLAFIN’s P/E is lower than its industry peers (27.4x). This implies that investors are undervaluing each dollar of CHOLAFIN’s earnings. As such, our analysis shows that CHOLAFIN represents an under-priced stock.
A few caveats
Before you jump to the conclusion that CHOLAFIN represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to CHOLAFIN. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with CHOLAFIN, then investors would naturally value CHOLAFIN at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with CHOLAFIN, investors would also value CHOLAFIN at a lower price since it is a lower growth investment. Both scenarios would explain why CHOLAFIN has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing CHOLAFIN to are fairly valued by the market. If this does not hold, there is a possibility that CHOLAFIN’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of CHOLAFIN to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for CHOLAFIN’s future growth? Take a look at our free research report of analyst consensus for CHOLAFIN’s outlook.
- Past Track Record: Has CHOLAFIN been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of CHOLAFIN’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.